The battle of ‘copper versus wheat’

Inflation’s a key risk for the industrial metals market

SAN FRANCISCO (MarketWatch) — Prices for industrial metals have been on an impressive run, with most posting sharp gains on bets of growing demand from emerging-market economies, but as China steps on its brakes and global inflation creeps in, metals traders may want to think twice.

Prices for aluminum and nickel have both gained in recent weeks. On the London Metal Exchange, aluminum prices rose 11% and nickel was up 31% last year.

Much of those gains came as data supported the idea that consumption from emerging market economies will continue to grow at a strong pace.

And as “emerging market demand has been the big driver behind industrial metals, these metals would also seem the most susceptible to any slowdown,” said Chris Mayer, a managing editor for Agora Financial and contributor to the Daily Reckoning.

“There is too much hitting these countries too fast,” he said, pointing out that emerging economies are getting hit by rising prices for food, oil and industrial metals, and the central banks of several big countries, including Brazil and China, are raising interest rates.

The HSBC Emerging Markets Index, which tracks purchasing managers’ indexes in 16 emerging markets countries, accelerated in the final quarter of 2010 as manufacturing rebounded. The index rose to 55.7 from a five-quarter low of 54.2 in the preceding quarter. Read earlier Emerging Reports report on HSBC index.

‘We are concerned about the possibility of some overheating in growth economies.’
David Coffin, HRAAdvisory.com

But inflationary pressures are a key risk to future growth, HSBC said in a press release dated Jan. 10, with input cost inflation quickening in the fourth quarter to the fastest level since the second quarter of 2008.

That, in turn, clouds the outlook for industrial metals.

“We are concerned about the possibility of some overheating in growth economies,” said David Coffin, editor of HRAAdvisory.com, which publishes newsletters dealing with the mining market. “China, but also India and a number of others, are seeing inflation start to become a factor.”

“If moves to deal with this continue, it could slow growth enough to impact raw material prices,” he said. “This will be all the more true if food prices also continue to rise since, obviously, funds go to that sector first.”

Inflation ‘fire storm’

A new middle class, with more disposable income to spend, has been developing in emerging market economies — adding to assumptions that commodity demand is set to rise.

‘The classic economic trade off is guns versus butter. Now you are making it copper versus wheat.’
Christopher Ecclestone, Hallgarten &amp; Company LLC

As people’s “tastes” change and savings increase, the world will need more primary inputs, or “grass-roots commodities,” to satisfy consumer demand for food and infrastructure needs, said Jonathan Barratt, managing director at Commodity Broking Services in Australia.

That higher-end consumption is part of the growth cycle playing out, said HRAAdvisory.com’s Coffin, but “since wage gains are uneven, this can hurt the poor and that can disrupt the economy and thus hurt metal markets.”

And low-income consumers remain a big part of the population mix among emerging markets.

“The classic economic trade off is guns versus butter,” said Christopher Ecclestone, mining strategist at Hallgarten & Company LLC. “Now you are making it copper versus wheat.”

Economies like Algeria or Rwanda may have to make that tough choice but, for now, China and Brazil aren’t doing that trade off, he said.

China and Brazil “seem happier to use their bounty of liquidity to indulge in inflation, which partly helps to cover the price rises,” he said. “So much of the metals are going into infrastructure in the BRICs that the decision on ‘wheat vs. copper’ is not being made by consumers, but by governments.”

That may soon change.

“Record food prices create social unrest and inflation because they impact the poor most,” said William Gamble, president of Emerging Market Strategies. “Many countries will use price controls, export restrictions, panic buying and subsidies — all of which makes the inflation problem worse.”

“Add in record metal prices and high oil and you have an inflation fire storm,” he said.

And government policies to offset that inflation will be unsustainable, he said. “Eventually the market reasserts itself and the bubble along with demand for industrial metals collapses.”

Offsetting risk

Of course, there are still ways to offset risks and reasons why the rally in industrials metals can continue.

Lower growth doesn’t mean lower usage, it means ‘lower growth in usage’,” said Hallgarten’s Ecclestone, pointing out that China growing at 5%, for example, instead of 10%, will still need 5% more copper than it needed last year. “What is apocalyptic about that?”

Besides, costs won’t rise evenly in the world, said Sean Brodrick, a natural resources analyst for Weiss Research and contributor to Uncommon Wisdom Daily. “Commodities are priced in U.S. dollars, so if your currency is rising against the dollar, that cushions the blow.”

Against that backdrop, the safest way for traders to approach the metals market may be the most obvious.

“Investors need to look at the potential for demand growth for specific industrial metals in developed markets,” said Sam Subramanian, editor of AlphaProfit Mutual Fund and ETF Newsletters.

Palladium, for example, will benefit from increasing auto sales both in the U.S. and abroad, he said, with global auto demand likely to increase 6% this year. The metal is used in catalytic converters, which regulate exhaust emissions from cars.

The ETFS Physical Palladium Shares
PALL, -1.29%
and the ETFS White Metals Basket Trust
WITE
which includes palladium, platinum and silver, offer “pure-play investment” in palladium, he said. Other options includes owning shares of palladium producers like Stillwater Mining Co.
SWC, -8.33%
and North American Palladium Ltd.
PAL, +0.00%

Copper’s an even bigger market favorite.

“By all means, keep your eye on Doctor Copper,” said Brodrick, who targets $5 a pound for the metal, possibly later this year or early next year.

Retail investors looking for exposure to copper should use an exchange-trade note such as the iPath Dow Jones UBS Copper Subindex Total Return ETN
JJC, +0.39%
or mining stocks that are moving with the price of copper, such as Freeport-McMoRan Copper & Gold Inc.
FCX, +1.63%
according to Sam Kirtley, chief executive officer of SK Options Trading.

“More sophisticated investors may use futures or consider options strategies, the latter being our preferred way to trade,” he said.

Kirtley expects prices for zinc, nickel and aluminum to “remain well supported this year,” but said they have “limited upside” with recent strength in these metals caused mainly by short-term factors, including weather-related supply disruptions from Australia for nickel and aluminum.

Mayer said some of the “quirkier specialty metals,” such as silicon metal, will do well.

Prices for silicon metal don’t support new investment, “and yet, there is growing demand from the solar industry” for it, said Mayer, adding that Globe Specialty Metals, ticker GSM on Nasdaq, is “well run with a strong balance sheet and low costs.”

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